EFFICIENT: The state of resource allocation the exists when the highest level of consumer satisfaction is achieved from the available resources. Competitive markets, absent of any market failure and especially market control by either side, is efficient. In particular, this feat is accomplished when the price buyers are willing and able to pay for a good--based on the satisfaction obtained--is equal to the price sellers need to charge for a good--based on the opportunity cost of production. In other words, the value (satisfaction) of stuff given up to get a good is the same as the value (satisfaction) of the good produced. Satisfaction won't increase by producing more of either.

An initial condition or statement of a model or theory that sets the stage for an analysis by abstracting from the real world. Assumptions are important to economic analysis. Some assumptions are used to simplify a complex analysis into more easily manageable parts. Other assumptions are used as control conditions that are subsequently changed to evaluate the consequences.

Assumptions form the foundation upon which theories, models, and analyses are constructed. They simplify and highlight the problem or topic under study. Even though assumptions often appear to be "unrealistic," when properly used they make it possible to analyze an exceedingly complex set of events.

Abstraction

Assumptions are inherently abstract and seemingly unrealistic. However, they make it possible to identify a specific cause-and-effect relation by assuming other influences are not involved. For example, the law of demand is the relation between demand price and quantity demanded. Demand, however, is also affected by factors other than demand price, such as buyers' income, the prices of other goods, or buyers' preferences. When working with the law of demand, it is essential to assume that these other factors do not influence demand when identifying the law of demand.

Is this realistic? No. Do these other factors affect demand? Most certainly. However, without an abstract assumption holding these other influences unchanged, the law of demand relation is lost in the confusion.

Two Reasons

Assumptions are used for two primary reasons--to simplify a complex analysis and to control an analysis.

Simplification: One important use of assumptions is to simplify an analysis. The world is complex. The economy is complex. A multitude of forces are perpetually at work. Making sense of the apparent chaos is the goal of science. This goal is pursued by focusing on one topic, one problem, and one segment of the world at a time. In so doing, it is essential to assume that other aspects of the world are unchanged or irrelevant. Simplifying assumptions often establish ideal benchmarks that can be used to evaluate real world conditions.

Control: Assumptions are also commonly used as control variables. The use of seemingly unrealistic assumptions makes it possible to control an analysis and to identify individual cause-and-effect relations. That is, at first a factor might be assumed constant (implementing that ceteris paribus assumption) merely to see what happens when the factor changes.

For example, the standard market analysis employs the ceteris paribus assumption to hold demand and supply determinants constant when deriving the market equilibrium. They are not REALLY constant. But, by holding them constant initially, each can be changed separately (that is, the ceteris paribus assumption is relaxed) to analyze how each affects equilibrium.

Misuse and Politics

Unfortunately, economic analysis occasionally makes excessive use of unrealistic assumptions, assumptions that not only define the problem but ensure particular conclusions. For example, the study of pollution externalities might begin with the assumption of a competitive market, free of market failures. In so doing, the problem of pollution is effectively assumed away, which is not only unrealistic, but defeats the purpose of the analysis. However, if the analysis is intended to "prove" pollution is not a problem, then the goal has been achieved.

Much like chemists occasionally blow up their laboratories, economists do misuse assumptions. Whether they realize it or not, economists are inclined to use economic theories that conform to preconceived political philosophies and world views. Liberals work with liberal economic theories and conservatives work with conservative economic theories. This, by itself, is no crime. The ongoing debate and competition of ideas brings out the best of both and enables a better overall understanding of the economy. However, the temptation to use unrealistic and unjustified assumptions that produce conclusions and support policies consistent with preconceived beliefs is always present. Doing so is not necessarily good.

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